Misperceptions of Interest Only Mortgages

Interest only mortgages are loans based on paying interest for a fixed period of 5 to 10 years followed by a higher principal plus interest payment for the remainder of the loan period. These loans are particularly popular with sub-prime or second chance loan borrowers who are trying to lower their interest cost and monthly payments.

A borrower who obtains an interest only loan hopes that having access to a loan with a low initial monthly payment structure, they can get back on track financially and eventually get out from under the terms of the interest-only loan.  

Interest-Only to Principal Plus Interest

A concern that arises regarding these loans is the point when it changes from an interest-only loan to a principal plus interest loan. During the initial interest-only period of 5 to 10 years, the borrower is paying a monthly amount that consists of a much lower interest payment. This can lull the borrower into a false sense about the true cost of the loan. Once the interest-only period comes to an end, the cost of the mortgage changes dramatically.

This dramatic change in costs can lead to financial hardship or duress for the borrower, including mortgage default and foreclosure. The fact that interest-only mortgages are targeted toward individuals with poor or bad credit as part of the sub-prime loan market makes them suspect as a proper loan for consideration. It may not be in the best long-term interest of the borrower to take on this type of loan obligation, given their situation.

Loan Interest Costs Compared

The cost of an interest-only loan to a sub-prime borrower will over time be more expensive than a comparable fixed rate principal plus interest loan. This is because interest-only loans are back loaded with respect to the cost, which is not realized by the borrower until year down the road. The step up from the interest-only payment to the combination interest and principal payment translates into an effective interest rate that is higher than a straight line fixed interest rate for the same amount of mortgage.

Educating Borrowers

Because of the higher risk of default and foreclosure that is present in the sub-prime, second-chance mortgage market, efforts are being made to educate consumers regarding the availability of mortgages and lending programs that are designed to protect vulnerable consumers. An interest-only mortgage loan may be a way for certain borrowers to obtain a loan and purchase their home. This must be tempered with such a borrower’s understanding of how the loan works and the chance that the payments will become more difficult to make once the principal payments are tacked on.